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Tuesday, March 16, 2010

Robber Barons Redux in the Derivatives Market?

A recent story from Bloomberg.com reported that two large banks, Goldman Sachs and J.P. Morgan Chase, are using their market power to secure extra large helpings of collateral in derivatives transactions with hedge funds. http://www.bloomberg.com/apps/news?pid=20601109&sid=af6uIAFTSorY. For example, Goldman reportedly obtained $110 billion more in collateral on derivatives transactions than it paid out. In effect, it got $110 billion in low cost funding that it could reinvest at a profit. J.P. Morgan Chase netted $37 billion in a similar way.

On one level, we're glad that hedge funds dancing in the derivatives market are subsidizing Goldman and J.P. Morgan. Otherwise, the Fed might feel compelled to print more money to ensure plenty of cheap funding for the too large to fail.

But the Bloomberg story states that these two behemoths of the financial markets had their way with counterparties because of their market power. In the post-2008 financial markets, there are only a few firms that offer some derivatives products sought by hedge funds, and those few evidently make their customers pay full freight and perhaps more.

On the level of economic theory, oligopolistic behavior is undesirable because the oligopolists extract "monopoly rents" from their customers--i.e., profits above the level that a truly competitive market would provide. This misallocation of economic resources enhances the power of the oligopoly, which can use that power to further entrench itself and secure more monopoly rents. To restate the point in plain English, oligopoly power allows the already megawealthy to become even more indescribably rich.

Surely we taxpayers, who have already subsidized Wall Street to the tune of multi-billions, are gratified to learn that those clever kids at Goldman and J.P. Morgan Chase can look forward to even more wealth. But let's also consider the impact of this collateral disparity on market risks. The derivatives market has a zero-sum quality. If a risk is transferred from one party to another, it doesn't disappear. It simply lands in the second party's lap, who must then figure out what to do with the hot tamale. In a similar way, if more, rather than less, of the hedge fund community's funding is transferred to money center banks, that leaves less for the hedge funds. Prudent hedge fund managers, after having their arms twisted by bank counterparties for extra collateral, would shrink their asset bases in order to keep risk levels in line with their reduced circumstances.

But this is Wall Street. Profits talk and prudence walks. Reduce your assets, and you reduce your money making potential. Do we really think that, just because GS and JPM have reduced their risk levels, their counterparties will do so as well? Or might it just possibly be that their counterparties would simply live more dangerously?

We've seen this video before. It was called The Grasping Counterparties Who Ruined AIG's Entire Day. Recall that AIG reached the brink because its derivatives counterparties, with the largest being Goldman, demanded more collateral than AIG could deliver. Surrounded by a pack of ravenous counterparties, AIG would have been torn to shreds except that the federal government appeared in the nick of time with $180 billion to drive (or rather, buy) off the wolfpack. Goldman claims it was fully hedged from AIG risk. But in order to do God's work it took the taxpayers' money anyway.

If Goldman's and J.P. Morgan Chase's counterparties are now at greater risk, where would that risk fall if the markets turn sour? It's possible that the derivatives markets have become more fragile because of the increasing concentration of market power in the hands a few money center banks. Locating any such fragility is difficult, because the absence of financial regulatory reform leaves us with only the fog of opacity of the derivatives market, circa 2008--well, 2010. Of course, if there is a blowup, the Fed can always print some more money. And that's okay, because there never, ever will be any inflation again. At least, that seems to be close to what some high ranking government officials have told us and they couldn't be wrong, could they?

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